Please Explain Index Funds

Question: In one of your recent columns, you state that “Index products are what are known as ‘passive’ investments. They simply track the performance of whatever index they are based on. If it rises, they follow suit. If it falls, ditto.”

How can this be? For a TSE-indexed mutual fund, is the money invested in stocks on the TSE in exactly the same proportions as the TSE as a whole? For example, if Nortel stock represents 10% in the overall value of the TSE, does the indexed fund also consist of 10% Nortel stock? Please explain the nuts and bolts of this to me.

The TSE 300 gained 30% last year. Does that mean that a fund indexed to the TSE also gained 30% (minus management fee)?

What about Index Participation Units? (IPUs) How are they different from mutual funds (besides the fact that they don’t require a management fee)?

Gordon Pape answer: Index funds operate just as you assume. The shares they hold reflect the underlying index, in exactly the same proportion. So if the TSE goes up 30%, an index fund geared to it will do the same, less expenses and management fee.

If you check threcord, you’ll see that in 1999 the Green Line Canadian Index Fund gained 30.5% while the CIBC Canadian Index Fund was ahead 30.4% because its MER was 10 basis points higher.

Index Participation Units (IPUs) trade on stock exchanges, unlike mutual funds. The benchmark IPU in Canada now is the new i60 unit, based on the S&P/TSE 60 Index. IPUs have a much lower MER than mutual funds. However, you will have to pay a brokerage commission to acquire them, whereas most index funds are no-load.

There is a full chapter on index funds, IPUs and similar products in my book Gordon Pape’s Investing Strategies 2000: Mutual Funds and Beyond if you would like more details.